Sunday, December 21, 2014

And so it begins… Collapsing crude prices are starting to make their way through the North American energy sector, as the most unprofitable oil & gas rigs are mothballed. Those flashing red numbers are not just on your screen any more.

Source: Baker Hughes

The closures have been particularly acute in Canada, where some 40 oil & gas rigs have been taken out of operation recently. In fact it's not clear if economists fully appreciate what's about to transpire with the Canadian economy. This decline in rig count is just the beginning.

Consider for example the situation with the Canadian oil sands - one of the more expensive sources of crude production. Even if prices recover somewhat, oil sands production will be winding down - nobody wants to operate money-losing businesses for a prolonged period. And those who believe crude will be back above $80/bl any time soon is deluding themselves.

Source: FT

Up until now, production from oil sands has fueled growth in other sectors, including for example transportation and housing in Alberta. This is about come to a screeching halt.

The national situation is not significantly better. Housing markets across the country have continued to rally, even as homes south of the border had undergone an unprecedented price adjustment. While many point out that the reason for avoiding a US-style housing crash has been a stronger mortgage market, that's only part of it. The global commodity boom in which Canada successfully participated is the main reason.

Source: Multiple Listing Service

Now as the commodity super-cycle has ended and energy prices collapsed, Canadian households are caught with near-record levels of leverage.

Source: National Post

Some have been pointing out that Canadian mortgage debt service ratio has continued to improve. However that measure is misleading, as it excludes principal payments. In reality the situation is much worse (see chart, h/t @ac_eco).

There is also the argument that Canada's economy is "diversified". Perhaps. But just to put the situation in perspective, take a look at the breakdown of the nation's trade balances.

Source: @Earthed , Maclean's

While economists will attempt to analyze the impact of energy prices on various sectors separately, when it comes to Canada, a number of economic components are quite difficult to decouple from one another. What's clear is that this exposure to energy is going to damage the labor markets, squeezing the nation's overextended households. And the knock-on effect won't be limited to a severe slowdown in residential construction growth. Consider for example the expenditures on renovations - something that's been supporting parts of manufacturing and other sectors. This is not going to end well.

Source: Scotiabank

The markets are already sensing the contagion effect from energy on the housing market, as Canadian property REITs take a hit. If oil prices remain anywhere near the current levels for a prolonged period - something the Saudis are aiming for (see post) - Canada's economy is in serious trouble.

Sunday, December 14, 2014

The Federal Reserve has been aggressively testing the various monetary tools that will give it additional flexibility during the rate normalization process. In addition to the Term Deposit Facility (see post), the Fed recently started testing the term reverse repo facility (Term RRP - see statement). Note that this is in addition to the Overnight RRP. For those who want to track this program, follow the updates here (see the spike at the end?) The Fed will provide a total of $300bn under the program, with the first such offering completed on Dec-8th. It was a 28-day "secured deposit" paying 10bp (annualized) for $50bn.

Source: NY Fed

At the same time the US Treasury has issued a larger than usual amount of treasury bills recently. Since the Term RRP with the Fed is effectively the same as purchasing a treasury bill (particularly at 10bp), the Fed's $300bn program (combined with the existing facilities) effectively "crowded out" the bills market. This ended up pushing short-term treasury yields higher - while yields on longer-dated treasuries kept falling (see chart).

The Fed's latest monetary tools "experimentation" has also drained some reserves and lowered the monetary base.

For those who still track the Fed’s total balance sheet, don’t – the balance sheet doesn't tell you much about the monetary stance when you have these new forms of “sterilization”. Of course all this is viewed as temporary and the reserves may yet return to their peak levels next year. And judging from current disinflationary pressures (see chart), the actual liftoff - when these tools are going to be implemented on a more permanent basis - may be as long as a year away. For now however these monetary experiments have been sufficiently large to raise short-term interest rates.

Saturday, December 13, 2014

If Mario Draghi was lacking ammunition to initiate an outright quantitative easing program in the Eurozone, he certainly has it now. Even the staunchest opponents will have a tough time arguing against the need for a more aggressive approach to monetary easing. Here are five reasons:

1. The take-up on ECB's TLTRO offering (see post) fell far short of the ECB’s goals. Indeed the demand in the second round of the offering came in at €130 bn, putting the total take-up at €212bn - well below the €400 billion allowance. Since the TLTRO financing is linked to bank lending, the program to some extent relies on demand for credit from businesses and consumers. And that demand has been lackluster in the past couple of years. Therefore the initiatives announced by the ECB last summer, including ABS and covered bond purchases, are simply insufficient for the type of monetary expansion (of about €1 trillion) the central bank would like to see in the Eurozone.

Eurosystem consolidated balance sheet (source: ECB)

2. Some Economic data out of the Eurozone shows recovery stalling. Italian industrial production and French labor markets are just two examples.

Source: Investing.com

Source: Investing.com

3. With the collapse of oil prices, the Eurozone is bracing for deflation. German 5-year breakeven inflation expectations are now at zero. And Europe's central bankers are fearful of repeating Japan's decade-long struggle with deflation.

Source: @PlanMaestro

4. While the euro has declined significantly against the dollar, it remains quite strong on a trade-weighted basis. This is putting downward pressure on prices (via cheaper imports) and is disadvantaging some of the Eurozone-based exporters. A more aggressive easing effort would force the euro lower.

TWI = "trade-weighted index" (source: @TenYearNote)

5. Finally, the euro area's sovereign risks are resurfacing once again - triggered by new political uncertainty in Greece.

The Guardian: - Mounting concerns over Greece’s ability to weather a presidential election, brought forward in a surprise move by the prime minister, Antonis Samaras, continued to unnerve investors ahead of the first round of the vote in the Greek parliament next week.

Under Greek law failure to elect a new head of state by the ballot’s third round on 29 December could trigger a general election. The stridently anti-bailout main opposition party, Syriza, is tipped to win that poll. The radical leftists have made a debt writedown and the end of austerity their overriding priorities if voted into office.

Although Samaras called the election in a bid to expunge the political uncertainty engulfing Greece, the slim majority held by his government, compounded by the leader’s repeated warnings of Greece leaving the eurozone if Syriza assumes power, has accelerated investor nervousness.

The nation's stock market is down 20% over the past 5 days as investors flee.

red = Euro STOXX 50, blue = Athens Composite

And Greek sovereign debt sold off sharply. In fact the 3-year government paper yield went from roughly 3.5% in September to 11% now. This situation alone would make most central bankers consider some form of monetary easing.

Mario Draghi now has five solid reasons to argue for QE and many expect the central bank to announce such an initiative in the next 2-3 months. However, while most economists covering the euro area agree on the need to take a more aggressive monetary action, the problem of implementation remains. Since the Eurosystem's (ECB's) balance sheet is in effect owned by member states, many in the core economies are worried about having to become the proud owners of large quantities of their pro rata share of periphery nations' debt. For the Germans in particular, the ownership of such debt is a major issue. A solution that is even remotely politically palatable across the Eurozone remains elusive. The ECB's independence and the euro area's legal structure is about to be tested once again.

Sunday, December 7, 2014

The latest US payrolls report presents a challenge for the Fed. As discussed back in April (see post), US labor markets are continuing to heal, suggesting that the rate "normalization" should be a serious consideration for the central bank. However the recent deterioration in commodities, especially energy, is "importing" global disinflation to the US (see post). In particular, the Saudi commitment to retake lost market share has sent shock waves through the oil markets (see post).

GCC is a diversified commodity index (source: barchart)

As a result, longer-term market-implied inflation expectations have fallen substantially.

The latest declines in expectations came after the recent FOMC minutes already showed increasing concerns at the central bank:

At the same time payrolls in the US are growing at a rate approaching the pre-recession peak (though still materially below what we saw in the 90s).

In fact the divergence between payrolls growth and inflation expectations is currently unusually high. Payrolls are driven by stronger US domestic economy, while inflation expectations are impacted by external factors, which creates this disconnect.

Red dot represents the current situation

This mismatch is causing a dissonance for policymakers and market participants, adding to the disagreement on the timing of liftoff. Current market expectations for the first hike now point to Q3 of 2015.

Source: CME

However if inflation expectations persist at these levels or worsen, it will be nearly impossible for the Fed to move on rates - irrespective of how much labor markets improve. The bet represented in the chart above is that energy prices will stabilize and/or growth in wages improves substantially by next summer - pushing breakeven expectations higher. But such an outcome, driven to some extent by factors external to the US, is far from certain.

What makes the timing of liftoff particularly difficult to estimate is the value of the US dollar.

Source: barchart

With a number of major central banks either easing or expected to begin easing monetary policy (diverging from the Fed), the rise in the relative value of the dollar will continue. That will bring inflation expectations even lower by weakening US import prices and pressuring commodities. If the strong dollar can make goods and to some extent services from abroad cheaper, there is less incentive for US-based firms to raise wages. Tapping cheaper markets abroad becomes more profitable.

And as the expectations of liftoff draw closer, the dollar will strengthen further, making it more difficult for the Fed to pull the trigger (what some refer to as a "self-correcting" mechanism). It's hard to envision the Fed acting unilaterally in the sea of looser monetary policy worldwide. The policy trajectory of the US central bank is therefore tied to a large extent to the global recovery, which remains elusive for now.

The Fed officials are keenly aware of premature policy tightening by a number of central banks, who were forced to reverse their decisions later.

Source: @themoneygame (Business Insider), Deutsche Bank

What some of these central banks didn't count on was the global nature of disinflation, over which they had little or no control (see chart). In the Fed's case, such a reversal would severely undermine the FOMC's credibility, sending policymakers back to the drawing board.
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Sunday, November 30, 2014

The chart below (and similar comparisons) has been circulated widely in the media and the blogosphere. It shows homebuilder optimism (as measured by the NAHB) far outpacing sales of singly-family homes in the United States. Naive reporters and bloggers have been arguing that builders are simply out of touch with reality. How could homebuilders possibly be almost as optimistic as they were prior to the housing recession if new single-family home sales are near multi-decade lows?

Source: @cigolo, Reuters

There are a couple of key reasons for the NAHB index decoupling from new single-family home sales:

1. Builders are targeting higher-end and luxury homes - a market where mortgage availability is less of an issue. That it why the median price of new homes sold is far above the pre-recession peak and continues to rise.

Source: @NickTimiraos

2. US homebuilders are also focused on multi-family structures - rental as well as some high-end condos.

Source: @NickTimiraos

Tighter credit conditions and some consolidation have resulted in reduced competition among homebuilders, with a number of local and regional players closing down after the recession. At the same time rental housing demand is on the rise (see post). Those well positioned in this space will do fine. Therefore, while it is quite popular to poke fun at the "giddy" homebuilders, one should rest assured these businesses are acting quite rationally. And so are their investors. Homebuilder shares have outperformed the broader market since the October correction (see chart).

Saturday, November 29, 2014

Although OPEC's decision to maintain current crude production quotas was not entirely unexpected (see post), the market reaction was violent. WTI crude fell by 10% over the last two days of the week.

At $66 per barrel North American producers have real problems on their hands. While Eagle Ford is still profitable, both Bakken and Permian Basin are in now the red.

Scotiabank: - Based upon an analysis of more than 50 oil plays across Canada and the United States, we estimate that ‘mid-cycle breakeven costs’ in the North Dakota Bakken (1.05 mb/d) are roughly US$69 per barrel and in the Permian Basin in Texas (1.63 mb/d) about US$68. While some producers have hedged forward at higher prices, if WTI oil remains around US$70 for more than six months, it appears likely that drilling activity will slow in more marginal areas of these plays as 2015 unfolds. Funding for independent oil producers will also tighten. However, the ‘liquids-rich’ Eagle Ford (1.45 mb/d) will be little impacted, with breakeven costs averaging only US$50.

That's why we've had such an extreme sell-off in US oil & gas shares on Friday (see chart) and Canadian shares underperformed (see chart). If prices persist at current levels for months to come, the Saudis will achieve their objective of dealing a blow to North American oil production. Current expectations of the US outpacing Saudi Arabia as the number one oil producer (see chart) will be shelved for some time. And the only thing the US government could do at this point to support the domestic oil industry is to begin increasing the Strategic Petroleum Reserve. Of course such a measure would be temporary and if global demand does not improve, prices will begin falling again.

Wednesday, November 26, 2014

As usual, economists will be paying close attention to Black Friday shopping, trying to get a glimpse of the overall retail sales this holiday season. Expectations this year are more optimistic than what we saw the last couple of years (see chart). Can we learn anything from Google search frequency statistics about trends for Black Friday? Here are some results.

1. Global search for Black Friday has been rising steadily since 2005.

Global trend

2. As expected, most searches originate in the US, but not all. The second on the list is Romania.

"Black Friday" relative search frequency by country

Why Romania? Starting around 2011 some retailers in Romania picked up on the US tradition and got consumers hooked on it (across the country).

"Black Friday" search in Romania

There is a similar pattern in the Bahamas (since 2009) and Jamaica (since 2007), though search frequency is no longer growing there. In Paraguay, Black Friday saw a one-time spike in 2012 and limited activity since.

3. Back in the US we see search frequency for Black Friday leveling off over the past three years - probably due to saturation.

"Black Friday" search in US

4. The most interesting piece of information is where in the US the "Black Friday" search is coming from. Here are the top rankings by state.

"Black Friday" relative search frequency by state

Note that except for Ohio, this list represents the six poorest states in the nation. While there is no direct proof, this data would suggest that poverty is an important determinant of interest in Black Friday offers/sales. Therefore the shopping volumes we see later this week may not be representative of the overall holiday sales this year.
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Sunday, November 23, 2014

The latest Reuters poll is showing 24 out of 43 economists projecting the first rate hike in the US by June of next year. The futures market is pricing liftoff by September. Citi's latest analysis puts it in December. And all of these forecasts are running way behind the so-called Taylor Rule, which is suggests that the Fed Funds rate should already be at 1.5%.

Source: @Schuldensuehner, Citi

In fact the US economy can easily handle non-zero short-term rates at this point. The banking system is quite healthy and can easily manage funding costs of 1.5%. Corporate borrowers can deal with slightly higher rates as well. And as far as mortgages are concerned (to the extend higher short-term rates extend to longer maturities), borrowers for whom payments become prohibitive at 5% vs. 4% should not be taking out a mortgage to begin with. Furthermore the issue with the housing market these days has more to do with tighter mortgage credit rather than rates.

But it's no longer as much about the US economy as it is about external factors. The international situation has made the Fed's policy planning much more complex. The monetary policy divergence among the major central banks is the issue at hand. With the BoJ suddenly accelerating its QE program, the PBoC cutting rates, and Mario Draghi hinting at a potential QE program in the Eurozone, the Fed is becoming increasingly isolated in its plans to begin rate normalization. Even India's RBI, who has kept rates elevated for some time, may begin to ease soon as the nation's inflation and money supply growth slows.

As a result of this divergence, the US dollar has been on the rise this year.

Of course the recent increase in and of itself is not tremendous relative to historical levels. However, given the disinflationary pressures around the world, the rising US dollar effectively "imports" disinflation into the US. Moreover, the massive drop in energy prices, caused by a combination of a significant rise in North American production and weaker demand globally (as well as the Saudi "dumping"), is adding to slower inflation. In fact, in recent months a paradigm shift has taken place. Weakness in inflation is no longer viewed as a temporary phenomenon as the longer-dated market-based inflation expectation measures turn sharply lower.

Furthermore, professional forecasters are also downgrading their long-term inflation projections.

Source: Deutsche Bank

Even consumer expectations of long-term inflation have shifted.

Reuters: A Thomson Reuters/University of Michigan survey released last week showed that consumers see inflation averaging 2.6 percent a year five to 10 years from now, down from 2.8 percent predicted last month and the lowest reading since March 2009.

It's not going to be about jobs going forward, in spite of the comments we continue to hear from the FOMC. The Fed's focus has shifted to inflation and inflation expectations. And no matter how low the unemployment rate falls, it will be difficult for the Fed to pull the trigger on rates, risking further strengthening of the dollar and more downward pressure on prices. It is possible the Fed will wait for growth in other major economies to stabilize before liftoff in the US. Which is why some economists (like those at Citi) are pushing rate hike expectations further out in time. Unfortunately the longer it takes to get there, the more disruptive the effect of normalization will be on global financial markets - as the Fed's zero rate policy moves into its 6th year and possibly beyond.

Wednesday, November 19, 2014

Improved pricing power for US firms? Hardly. Did you ever have the feeling of being ripped off at the gas station when oil prices are falling while prices at the pump barely move? Well, it’s not just a feeling.

GS: - The headline PPI rose 0.2% in October (vs. consensus -0.1%). The surprise was entirely due to core prices, which rose 0.4% (vs. consensus +0.1%), while energy prices declined 3.0%. Within the core, the volatile trade services category—which measures retail and wholesale margins—rose 1.5%, adding three-tenths to the core. Drilling down further, a sizable part of the jump in trade services came from a huge 26% month-on-month increase in fuel retail margins (i.e., gasoline stations). While counterintuitive in light of the decline in energy prices on the month, the increase in this category reflects retail prices declining more slowly than wholesale prices. On balance, we would heavily discount this month's report in light of the volatility in trade services. The core PPI according to the "old methodology"—finished goods less food and energy—increased a more modest 0.1%.

For nearly a decade, China’s maturation from a major exporter into a global economic dynamo has occurred with the embedded assumption that CNY will continually strengthen. This made sense given the backdrop of a currency that has been held well below a market driven rate by the peg to the USD and then managed float. China’s Yuan policy also included strict foreign capital controls that significantly limited outside investors’ avenues to partake in this compelling carry-trade.

Outperformance of CNY Carry Trades (Sharpe Ratios)

Source: Bloomberg

China has begun to liberalize its financial system and Yuan policy. One major step was greatly relaxing restrictions on the Hong Kong based offshore Yuan (CNH). While this currency is somewhat tethered to the onshore Chinese Yuan (CNY), it is at the end of the day a market driven currency. The CNH became the funnel for foreign money to participate in the carry and for onshore entities to borrow in foreign currency.

CNY-CNH Spread

Source: Bloomberg

The Currency War Stresses

As the PBOC pursues internationalization of the CNY, the currency has been freed to appreciate in increasingly looser trading bands, currently 2% from the fix. This has occurred while the Chinese economy attempts to pivot from largely being export and investment driven to more consumption and services driven.

Currently China’s export sector is under significant pressure from some of its largest trading partners via the BOJ and ECB’s forward balance sheet expansion, driving down their currencies. Exacerbating this move is the FED ending QE and speaking to further policy normalization putting upward pressure on the USD and by extension CNY.

The stresses from exchange rates are likely not in synch with the PBOC’s timeframes for allowing services and consumerism to fill the gap left by exports.

This puts direct pressure on China’s exports during a time when aggregate demand out of EU is weak and Japan is very shaky. That said, China’s pivot in trade and economic ties is directed at AXJ (Asia ex-Japan).

Internal Credit Market Stresses

The PBOC has gone to great lengths to provide funding facilities to the overextended and cycling down credit markets while avoiding a wholesale policy cut (benchmark rates and required reserve ratio). The latest iteration, the Medium-Term Lending Facility, provided 3-month liquidity at 350bps to the tune of 769.5B Yuan in Sept and Oct.

A continued deterioration in credit markets would warrant a move on benchmark rates and required reserves. As this possibility grows it is likely to be reflected by higher vols.

Positioning and Market Structure Risks

Given the long running, strong performance of the CNY and CNH carry trades over the past few years and the rapid growth in the offshore currency market, it is reasonable to expect net exposure is large and leveraged with investors and financial institutions. Furthermore, the size of cross border trade with China has led RMB to be the 2nd largest trade finance currency. This leads me to believe that foreign corporates may have large exposure to the carry via RMB trade finance arrangements and is evidenced by over-invoicing. Furthermore, this could be resulting in a favorable and potentially fleeting skew to the underlying economics of trade with China.

Anecdotally, having spoken with a businessman who imports from China, I sensed more excitement about his exposure to the currency than the underlying business.

Summing it up

As described above, a confluence of events and circumstances exist that cause me to be wary of the engrained (but increasingly questioned) assumption of a one-way path (and trade) for the Chinese currency. In fact, I would put a far better than 50/50 chance that the CNY and CNH will experience a period of unprecedented depreciation and volatility over the next 12 months. Future volatility will likely exceed the bout of volatility experienced in 1Q2014 brought on by the PBOC to shake out one-sided bets. The implications would be hugely disruptive to global markets.

USDCNH 2 week historical volatility vs. 1 month implied volatility

Source: Bloomberg

Implied vol rerated higher with the PBOC doubling of the USDCNY trading band to 2% on March 17, 2014.

Possible Triggering Scenarios for Disruptions

An external market shock- This could be broad market volatility brought on by the FED’s positioning away from ZIRP that will have spillover on the EME’s and carry trades. Market volatility (risk-off environment) could also come in the form of credit market contagion stemming from the energy space (which makes up ~18% of N.A. HY).

PBOC broad based monetary policy loosening (this includes changes to FX trading bands, new cheap money lending programs and aggressive use of their balance sheet)- This can come in response to; (a) further credit market deterioration; (b) weak economic and inflation prints; and (c) pressures exerted by the current round of currency devaluation by other central banks.

Emergence of an alternative regional or global currency scheme, outside of the existing system

Potential Mitigants

Large pools of incremental foreign capital that would find local currency products attractive if a risk-on environment firmly takes hold

Wednesday, November 12, 2014

A comment in last night's Daily Shot on the situation in Ukraine and Russia has resulted in a flurry of responses from the readers. Given how charged the situation is - both on the ground as well as globally - it's helpful to have a discussion on the topic. To start with, here is the original statement - which was clearly one-sided:

The Ukrainian currency (hryvnia) is in free-fall- almost 20 to the euro now – with violence flaring up as ceasefire collapses. According to the Moscow propaganda machine, the oppressed Russians in eastern Ukraine are fighting the evil Western “fascists”. It’s working well for Putin in maintaining popularity.

Source: Investing.com

Below are two of the numerous "letters to the editor" in full:

1.

Dear Author,

I’m personally so disappointed of your one-sided perception of the world. I have a plea for you - please be more politically correct when you are saying this: “According to the Moscow propaganda machine, the oppressed Russians in eastern Ukraine are fighting the evil Western “fascists””. Please, take 5 min of your time and look at the photos and video in the Internet - there are plenty facts of fascists on the streets in Ukraine. Don’t be so naive and look what West did in Ukraine starting this “colour revolution” (bombing civil people and Ukraine officials refuse to talk with half of the country, as they do not adhere to Western views). Is it democracy? When Ukrainian fascists burned 50 people in building in Odessa, people who want to say that they disagree with what is happening now - is it not fascism? I don’t talk even about Donbass, where thousands of civilians were killed by ultranazi group Right Sector and Ukrainian Army.

And who gave the power to US to start this revolution and then to interfere to this situation? It’s over 10 000 miles from US borders? Why NATO is expanding year to year trying to make artificial evil from Russia & China? Think about it...

And please, when you say something look at the situation from both sides, don’t be biased by CNN, BBC, Bloomberg, etc. - they are showing only one part of the real situation!

Best regards,
Your Reader

2.

Hello,

Thank you for your most excellent charts.

I am prompted to reply to your comment about the "Russian propaganda machine". This type of phraseology is becoming nnoticeablymore frequent.
By comparison to the lack of subtlety of Russian propaganda, Western propaganda is perhaps more sophisticated (in the true sense of the word), and all the more insidious and dangerous because of it.

A knowledge of history and of geography allows one to see at least some grains of truth in the Russian statements. The perception (and the implication) that the propaganda is all one-sided is itself a product of Western propaganda. Can you not see the irony?

Regards,
Glenn

Readers are invited to comment on this issue - either in the comment section or on the survey below.

Tuesday, November 11, 2014

Yesterday the Bank of Japan announced that it will be buying Japanese equity ETFs as well as property funds (REITs) to boost demand for risk assets. The BoJ has done this before but the timing of this announcement suggests a new push to accelerate monetary easing. This action is coming on the heels of the Government Pension Investment Fund's (GPIF) recent announcement that it will increase its allocation to Japanese and foreign shares to 25% from 12%.

The yen continued to sell off as a result of this accelerated easing and is now hovering around a 7-year low.

With the support from weaker yen and the official sector's renewed demand for shares, the equity markets had one way to go. The Nikkei 225 broke through 17k - a levels we haven't seen since 2007.

But while investors cheer this flood of liquidity, Japan’s lower-wage workers are being left behind. Wage increases in Japan are simply not keeping up with rising import prices (due to weaker yen) as well as with higher consumption taxes. And as the yen takes another leg down, many of Japan's workers, especially those who are non-union and part-time, will see their real wages decline further. Meanwhile, financial assets will be hitting new highs.

Source: Natixis

For those who believe that "unconventional" monetary easing widens the gap between the wealthy and the poor (and there has been plenty of debate around the topic), Japan could become a prime (and possibly extreme) example of QE-driven inequality.

As a further confirmation of this trend, today's report on household sentiment was worse than expected. Negative real wage growth is just not being offset by rising share valuations - especially for households that simply have not participated in the rally. With no end in sight for BoJs unprecedented monetary expansion, the nation's households are likely to face more hardships ahead.

Sunday, November 9, 2014

Once again, a great deal of confusion surrounds the European Central Bank's current policy objectives as well as the nearterm action expectations. Let's try to tackle the subject in a Q&A format.

Q: Since the policy change announcement back in June, what has the ECB accomplished?A: In addition to lowering short-term rates, the ECB has launched the TLTRO program (4-year cheap loans to banks) and began its third covered bond buying program (these bonds are issued by banks and secured with loans).

Q: What has been the impact of the ECB's interest rate reductions?A: The overnight benchmark rate has been set to near zero and the excess reserve rate has been moved to negative 20bp to incentivize banks to deploy capital. This has resulted in negative overnight interbank rate - banks pay each other to park their cash (which is still cheaper than parking cash with the ECB).

Overnight interbank rate in the euro area (source: emmi)

Furthermore, the euro's decline that resulted from negative rates and a possibility of further easing is expected to provide support for the export-dependent euro area nations.

Q: Has the rate action resulted in more lending in the euro area?A: The immediate reaction of the area's banks to the negative deposit rate was to buy massive amounts of sovereign debt, including periphery bonds. This has resulted in unprecedented declines in government bond yields across the yield curve.

There is evidence however that credit conditions in the euro area are beginning to ease. Growth in broad money supply measures for example has improved markedly.

M3 YoY (source: ECB)

However, it remains unclear whether monetary policy had much to do with this development. Instead the banking system deleveraging cycle, which started a few years ago, is gradually ebbing. Moreover, the conclusion of the ECB's stress tests should help banks deploy more of their balance sheets in the private sector without the uncertainty surrounding the stress testing process hanging over them.

Q: How much in TLTRO loans has been taken up by the banking system thus far?A: About €90bn - see story. This is well below some of the more conservative projections.

Q: How much ABS (asset backed securities, such as credit card and auto loan receivables) and covered bonds has been purchased since the announcement of the program?A: The ECB has acquired a small amount of covered bonds but no ABS thus far - see schedule.

Q: What has been the impact on the Eurosystem's (ECB's) balance sheet?A: The impact has actually been a net decline, as banks continue to repay their MRO and the original LTRO loans.

Eurosystem total balance sheet (source: ECB)

Q: Why hasn't the ECB been able to buy more covered bonds and ABS in order to have a visible impact?A: According to Credit Suisse, the total amount of qualifying ABS and covered bonds the ECB could purchase is around €140bn. The volume is insufficient for the ECB to accumulate substantial amounts of paper without massively overpaying and disrupting this market. And even if the ECB did purchase that whole amount, it would take too long and have only a limited impact on the balance sheet expansion (note: this is roughly the amount of paper the Fed would buy in 2 months during QE3).

Q: There has been some talk of the ECB buying corporate bonds as well. Couldn't that help grow the balance sheet?A: Corporate bond purchases are a possibility, given the ECB can no longer afford to wait for the banking system to act as the area's policy transmission mechanism. According to Credit Suisse however, only about €100bn of corporate bonds would qualify/ be available for such a program. While it sounds like a large amount and would certainly cut borrowing costs for companies, the amount is insufficient to restore the Eurosystem's balance sheet to the 2012 levels.

Q: How much then does the ECB need to expand its balance sheet in order to be credible?A: As discussed back in September, the ECB should probably grow the balance sheet by about €1 trillion. And the only way to achieve that is to augment existing programs with a more traditional QE effort that includes buying government bonds. Up to now there has been resistance from some Governing Council members (particularly) Germany, but supposedly Mario Draghi has been able to build consensus for such expansion - see story. That is why we had a rather sharp market reaction to the latest ECB press conference (see chart). Yet Draghi continues to downplay the €1 trillion balance sheet "target".

Credit Suisse: - ... ABS and covered bonds add up to
€140bn-odd of potential purchases. Adding a (putative) €100bn of corporates is
wildly insufficient to achieve the "target" [€1 trillion]. This target therefore has to be
downgraded, in our view, to "something I believe I might have mentioned" while
the much more thorny issue of "proper" (government) QE is addressed.

Q: Why do many of the Governing Council members all of a sudden are convinced that such a drastic action (€1 trillion expansion) may be needed?A: The persistently weak inflation readings have convinced them that Japan-style deflation risks in the Eurozone are quite real.

Source: ECB

Q: When (if at all) will the ECB begin to purchase government bonds?A: The ECB is likely to wait on any traditional QE for some time, even though it has started to prepare for it (some ECB employees have been asked to dust off the old Securities Markets Program - SMP). The goal is to see if another round of TLTRO will meet with more demand and if inflation stabilizes on its own.

Q: Will all this monetary activity by the ECB stem the declines in inflation?A: The technique used thus far has been to talk down the euro by hinting that a "bazooka" monetary event is on its way. That approach has worked. Whether the weaker euro will ultimately end up generating a higher sustainable inflation rate remains uncertain.